Econ 101: The Evolution of Banking

*Note: I’m just going to pretend it hasn’t been over 9 months since the previous post and continue on as if it were the next day. You may want to re-read it as a refresher, however.*

We’ve now seen how money goes from being an item with both use-value and exchange-value (e.g. gold, silver) to an item with only exchange value (e.g. warehouse receipts for gold or silver). We need to know a bit more about banking’s history if we want to understand some of the implications of this.

Over time, banks begin to notice that people rarely withdraw all of their money – gold, in our example – at once, and that a large amount of gold is just sitting around the warehouse all the time. Since anyone’s gold is identical to the same amount of anyone else’s gold (a necessary property of money, after all), people also rarely demand their specific gold deposit. The bank begins to see the gold in their warehouse as an asset that can be loaned out for additional revenue, rather than as someone else’s property that is being kept in safe storage. As long as there’s enough gold left in the warehouse to meet the demands of the depositors, what harm would there be? The bank may then establish some fraction of the total gold to be reserved for depositors and loan out the rest. This system is called Fractional-Reserve Banking.

The great problem with Fractional-Reserve Banking should be immediately obvious. As soon as the depositors demand more of their money than the bank has kept in reserve, the bank is shown to be insolvent and has to close. It has defrauded its customers by claiming to keep their deposits safe while actually taking those deposits for itself and selling them off in the form of loans. Fractional-Reserve Banking could still conceivably be workable in this instance, as long as the bank was able to call in its loans and restore the depositors’ gold more or less on demand. It would still be fraud, but of a type that could be easily rectified. However, for one thing, calling in loans is never instant, and the full amount can never be instantly repaid; if it could, there would be no reason to take out a loan in the first place. Furthermore, once warehouse receipts are being traded as money, then the bank need not even lend out the actual gold; it can simply print receipts for gold that doesn’t exist and lend those out. Again, as long as there is enough gold to meet depositors’ demands, who would know? The problems multiply here, however.

Since fewer people are demanding actual gold, the bank is free to become more liberal with its lending. It creates more receipts and lends them out, effectively creating more money. This process of money-creation was originally called inflation because it inflates the total supply of money. All of this extra money out in the world now begins to dilute the spending power of the money. The amount of goods and services in the world hasn’t changed, but with more money available to purchase those same things, prices begin to rise. This rise in prices has come to be known as inflation because that’s the most noticeable aspect for the public-at-large, but originally inflation simply referred to the supply of money getting larger.

With prices rising, people can’t buy as much stuff for the same amount of money and so are more likely to continue drawing down their bank account to have access to more and more money. As mentioned above, this will eventually cut into the bank’s reserves. When a customer of a bank sees other bank customers withdrawing more and more money, that person gets concerned that the bank may run out of money before he can get his out, and so he’ll join in the draw-down. This is a reasonable concern since, if you recall, more receipts exist than actual money to cover them. This rapid and accelerating withdrawal of money from a bank is called a “run” on the bank, and in a run, the point will eventually be reached when the bank is shown to be bankrupt and will be forced to close.

There have been two major institutions established to guard against bank failures due to being legally obligated to give out more money than they can get their hands on: deposit insurance companies and a national central bank. In the United States, deposit insurance is provided by the Federal Deposit Insurance Corporation (FDIC), and the national central bank is actually a group of banks called the Federal Reserve System. I won’t dwell on the FDIC except to say that, by insuring a depositor’s account up to a certain amount, and being backed by “the full faith and credit of the United States” – a euphemism meaning “tax dollars” – it simply encourages the banks to be more careless in their loans and in how much they hold in reserve. The Federal Reserve System, however, warrants more discussion, but again I’ve run out of space. So, seriously this time, the next post will deal only with Central Banking and the Federal Reserve System. I’ll try to keep it short.